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Problem Set 2
ECON C181: International Trade
Alejandro G. Graziano
Spring 2024
Due on Monday, March 11th by midnight. No late problem sets will be accepted.
Submissions are made via Gradescope. Please set up a Gradescope account if you do not already have
one. Use the code XX6WV5 to enroll in this course.
Submissions can be handwritten and scanned or typewritten.
Please, pay attention to the organization of your answers. Always keep the order of the questions,
write legibly, and clearly indicate what you are doing. Don’t forget: GSIs will only give you credit if
they can read and comprehend what you have written.
After derivations that need several steps, always mark your final answer clearly: put a box around
it, underline it or highlight it. You should aim for brief, concise explanations.
GRADING: Each question (e.g. Monopolistic Competition), will receive a check/no check if fully
completed, regardless of the accuracy/correctness of the results. The final grade is the share of
questions with checks (e.g. if two out of the four questions were completed, then it would be 50%).
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Monopolistic Competition, basics
Answer the following questions. Explain in each case.
1. If a firm that uses a production process that yields economies of scale charges a price equal to
, then profit will be
(a) average cost; strictly negative
(b) average cost; strictly positive
(c) marginal cost; strictly negative
(d) marginal cost; strictly positive
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2. In the monopolistic competition model, a cost saving technological change that reduces F will
the number of firms and
price.
(a) increase; increase
(b) decrease; decrease
(c) increase; decrease
(d) decrease; increase
3. In the monopolistic competition model, where demand is given by Q = S
1
n −b
P − P̄
firms with
lower marginal costs:
(a) charge lower prices and lower markups
(b) charge higher prices and lower markups
(c) charge lower prices and higher markups
(d) charge higher prices and higher markups
4. In the monopolistic competition model we have studied in the class, what is the reason for the firm to
want to charge a lower markup in a foreign market than in domestic market in the presence of trade
costs?
a) Trade costs imply that supplying foreign markets is more costly, and this leads firms to a less elastic
part of the demand curve.
b) Consumers need to be induced to buy foreign goods with discounted prices.
c) Trade costs imply that supplying foreign markets is more costly, and this leads firms to a more
elastic part of the demand curve.
d) Foreign markets always have tougher competition.
5. Intra-industry trade is likely to dominate trade flows when which of the following exists?
(a) large differences between relative country factor endowments
(b) homogeneous products that cannot be differentiated
(c) constant average cost industries
(d) small differences between relative country factor endowments
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Monopolistic Competition
Consider an industry with monopolistic competition and demand
Q = S[
1
− b(P − P̄ )]
n
2
1. Answer the following questions analytically and explain economic intuition.
(a) How does demand depends on the number of firms n and the average price P̄ ?
(b) How does the equilibrium number of varieties depends on the F and the size of the market S?
(c) How does the equilibrium price depends on the F and the size of the market S?
2. Now assume that S = 2000 and b = 2 and imagine that firms have marginal cost c = 5 and fixed cost
F = 10.
(a) What is the equilibrium n and P̄ ?
(b) Assume that there is some firm that takes this demand curve as given with n and P̄ are derived
above. What is the maximum marginal cost under which the firm would be able to sell in this
market?
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Monopolistic Competition and Trade
Wine producers are located in two markets: Argentina and Chile. They engage in monopolistic competition
and all firms have marginal cost equal to c = 1, fixed cost equal to F = 200, and a parameter b reflecting
sensitivity of quantities to prices equal to b = 0.2. Argentina has market size SA = 2560, and Chile has
market size SC = 1440 (Recall that in this model we have Q = S[1/n − b(P − P̄ )]).
1. Derive what happens to the number of varieties, price, the markup and quantity as the two markets
integrate. For which market are the absolute changes in prices and firm quantities larger?
2. In the standard analysis we have ignored trade costs. Imagine instead that there is a per-unit trade
cost t for selling in the other market, and that t = 3. Under these circumstances, is there trade or
not? To solve for that, you have to check whether a Chilean firm would find it profitable to export
to Argentinian market and whether an Argentinian firm would find it profitable to export to Chilean
market.
3. Now imagine that t falls to 1.5. Is there trade or not? If yes, are both countries exporting now?
Without solving for equilibrium, argue how do exporters in a given market compare to domestic firms
in terms of their prices, quantities sold in this market and markups?
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Heterogeneous Firms and Trade
Suppose that the demand curve is given by: Q = S[1/n − b(P − P̄ )], where P̄ = 5,S = 100, b = 0.1 and
n = 10. Let us consider various firms with different marginal costs.
1. Derive the marginal revenue curve for the firm (M R(Q)).
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2. Consider a firm with marginal cost c = 3. What quantity does it produce in equilibrium?
3. Suppose that the country opens to trade. As a result, in the new equilibrium we now have: S = 200,
n = 20 and P̄ = 4. Does that firm (c = 3) increase its production Q? Explain.
4. Answer questions (2) and (3) for the firms with marginal costs c = 2 and c = 4. Explain the difference
between the answers.
5. Suppose the all firms have a fixed cost of production equal to F = 5. How does trade opening affect
firms with c = 2, c = 3 and c = 4?
6. How does trade opening affect consumers welfare? (no calculations required)
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